Working Paper: CEPR ID: DP18644
Authors: Giancarlo Corsetti; Fred Seunghyun Maeng
Abstract: Uncertainty about a government willingness to repay its outstanding liabilities upon auctioning new debt creates vulnerability to belief-driven hikes in borrowing costs. We show that optimizing policymakers will eliminate such vulnerability by accumulating reserves up to ensuring post-auction debt repayment in all (off-equilibrium) circumstances. The model helps explaining why governments hold significant amounts of reserves and appear reluctant to use them to smooth fundamental shocks. Quantitatively, the model explains reserve holdings up to 3% of GDP if debt is short term, 2.4% with long-term debt—as long bond maturities mitigate vulnerability to belief-driven crises.
Keywords: Sovereign Default; Foreign Reserves; Self-Fulfilling Crises; Expectations; Debt Sustainability
JEL Codes: E43; E62; F34; H50; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Uncertainty about a government's willingness to repay its liabilities (F34) | Vulnerability to belief-driven hikes in borrowing costs (F65) |
| Accumulating reserves (D25) | Mitigate vulnerability to belief-driven hikes in borrowing costs (F65) |
| Accumulating reserves (D25) | Ensuring debt repayment in all off-equilibrium circumstances (F34) |
| Long bond maturities (E43) | Mitigate vulnerability to belief-driven crises (E71) |
| Reserve accumulation (F32) | Maintain fiscal stability (E63) |
| Optimal reserve and debt management (H63) | Reduce vulnerability to instability due to intraperiod uncertainty (D84) |
| Reserve accumulation (F32) | Reduce yield spreads on government bonds (E43) |
| Government managing reserves optimally (E63) | Keep the economy in a good equilibrium (D59) |
| Good equilibrium (D50) | Lenders consistently offer favorable bond prices (E43) |
| Favorable bond prices (G12) | Prevent belief-driven crises (H12) |